Child Tax Cliff

Lost in the debate over how the looming fiscal cliff might affect taxes on the rich and cuts in defense spending is a little-followed portion of the Bush tax cuts: the child tax credit. Unless Congress renews the law, the $1000 refundable tax credit is scheduled to be cut in half at year-end.

The child tax credit is one of those rare Washington accomplishments: a left-right compromise. Conservatives like the credit because it reduces taxes and supports families. Liberals have supported it because its benefits are progressive and provide aid to some of the most vulnerable populations.

But in the hurly-burly of the budget debate, the child tax credit is mentioned as a major tax expenditure that adds to the deficit. According to the Joint Committee on Taxation, the combined cost of the child tax credit and the earned income tax credit comes to about $77 billion per year. That compares with $110 billion for the mortgage interest deduction and the exclusion of capital gains on principal residences, or $42 billion for the tax exemption on interest income from municipal bonds. It’s real money.

And the credit has other, pernicious effects. Because the benefit phases out over time, it has the effect of increasing the effective marginal tax rate of people who receive it. Right now, for people earning between $15 and $40 thousand a year, if their income goes up $10 thousand, their net take-home pay only goes up between $1 and $2 thousand. That’s a powerful disincentive!

And because of different rates for married couples versus singles, the credit creates a significant marriage penalty for moderate-income families. A working single mother who marries will lose a host of federal and state support payments, totaling up to $20 thousand.

So some lawmakers want to scrap the credit altogether, removing the distortion and reducing the deficit at the same time. That would be a mistake. Our economy depends on having an expanding workforce, and raising children is expensive. Support from the tax code is modest, compared with the rest of the world.

The child tax credit is worth saving. Let’s hope policymakers can cut the Gordian Knot of tax policy, and reduce how it warps our economic and social systems.

Douglas R. Tengdin, CFA
Chief Investment Officer
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